Trading On Wall Street Has Lost Much Of Its Vigor

The New York Fed conducted a study concluding that because of the pandemic, traders no longer have the psychological strength to place fearless bets due to the psychological effects of the event. It is possible that this will fundamentally alter the way markets operate as we know them today.

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Researchers from the Federal Reserve Bank of New York, the University of Southern California, and University College London published a study in December looking into what cognitive skills make successful traders in their study. As part of the series, they look at non-cognitive skills such as agreeableness and conscientiousness, as well as cognitive skills. Rather than looking at what makes traders different than the rest of the population, they focus instead on how the pandemic has affected the personalities of traders as well as non-traders.

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This study suggests that we are now experiencing a trading environment that is less bold and more cautious with implications for the reaction function of financial markets that are very different from what we've become accustomed to over the years.

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Many of the early studies on behavioral finance were based on the assumption that humans have tendencies that are near universal. That led to the development of work that acknowledged the differences between individuals, but they were generally assumed to be set early in life and to remain constant for the rest of the individual's life. Behavior finance theories that assume that adults' personalities can be malleable over the course of their lives have only become mainstream in the last ten years or so. These new ideas can be tested in the context of the pandemic, which is probably the largest mass trauma to date. Are there any changes in the personalities of traders as a result of the pandemic? How does that affect the financial markets in the long run?

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While it is a new field of academic study, this concept is one that has existed for thousands of years. The general perception is that traders have been traumatized by some financial crisis, and as a result, risk-taking has declined as a result, thereby removing liquidity from the market and lowering valuations as a result. The majority of theories about financial bubbles and panics, as well as many trade theses and strategies, are psychological in nature. None of this is rigorous, and much of it is based on crude psychological stereotypes and superficial economic logic that is rooted in crude psychological stereotypes.

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It may come as a surprise to learn that the New York Fed study found that traders score higher on agreeableness - which includes trusting others and not finding fault in others - than a control group of students. Traders are supposed to be skeptical, if not suspicious, at all times, always looking for faults and thinking in contrary directions. On a scale of 1 to 5, there are almost no disagreeable traders; they are all moderate or high on the characteristics scale. However, there can be a wide range of levels of students, from low, to moderate, and high. Having a high level of agreeableness does not seem to be necessary for trading, but a low level of agreeableness seems to be a disqualification for trading. 

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How did the pandemic affect the world? There was a considerable decrease in traders' agreeableness, from a level far above the student level to a level far below it. The agreement of the students did not change in a significant way, so it was not something that affected everyone in the same way. As a result, the effects on traders who had been adversely affected in some way - physically, economically, or even in a personal life situation - were much greater. There was, however, an unexpected finding that, among students, the decline in agreeableness was much smaller, but only among the students who had been least affected by the pandemic.

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In addition to this, another important change was in a trait the authors call "locus of control," which refers to the degree to which people feel they have control over events and directions in their lives. Here, traders scored much higher than students on the “feeling in control” test, as it appears that traders need to feel in control in order to trade successfully. It would seem that traders are supposed to have great respect for the market, as well as randomness, which would seem to suggest that they have a low locus of control in relation to the market. In fact, it seems that traders need a high locus of control to summon the psychic strength to be able to make bold bets under uncertain conditions.

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In addition, the locus of control has been crashing for traders as well, although it remains well above student levels, which have not changed in any significant way. The impact of the pandemic on traders' lives was also the same whether they reported a high or low impact of the pandemic on their lives.

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We still don't know whether this was a temporary or permanent change based on the results of this study, as this is just one study. Nevertheless, if the data is taken at face value, it would appear that the market could be significantly more cautious as a result. It is unlikely that traders who are suspicious and do not trust each other and do not feel in control are going to make bold trades. It is possible that those traders who survive the specific traumas of trading during pandemics will be the market leaders of the next few years, especially if the younger generation was not affected, which seems to be the case in this study anyway.

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It is also important to ask whether this type of research will contribute to important insights into the market in the future. Will we be able to learn how markets shape traders' personalities, and how these personalities are then able to affect their behavior on the market? Is this going to remain merely an academic curiosity of little practical importance or will this become something more? Perhaps the next paper from this team will be able to answer some of these questions.